Sovereign Debt Could Be 2010’s Subprime

Greece, Spain, Ukraine, Austria, Latvia and Mexico are among the nations in danger of sovereign debt default, putting the global economic recovery from the recession at risk. Sovereign debt is the debt of nations. For example, U.S. Treasuries are backed by the “full faith and credit” of the government; similarly, other countries sell bonds to raise money to pay for programs such as armies and public healthcare. When a nation defaults on its sovereign debt, it means they are unable to pay their creditors. Dubai escaped default when its oil-rich neighbor, Abu Dhabi, bailed out the emirate to the tune of $10 billion. Also in trouble – though to lesser degrees — are Ecuador, Argentina, Grenada, Lebanon, Pakistan and Bolivia.

A default on sovereign debt is potentially even more disastrous than last year’s subprime meltdown because it has the potential to lead to geopolitical volatility, social unrest and even war. Investors who have purchased sovereign debt – which typically is perceived as safer than corporate debt because countries can raise taxes and increase tariffs to raise cash to pay their debts – could see some extremely poor returns.

In a book entitled This Time Is Different: Eight Centuries of Financial Folly, authors and economists Ken Rogoff of Harvard and Carmen Reinhart of the University of Maryland state that “Since 1970, nearly half of sovereign defaults have occurred in nations with debt-to-GNP ratios of 60 percent or more. This makes sense: As a country’s debt starts to approach the size of its total economy (or GNP), it gets harder to make their payments, just like an individual whose debts start to eat up all (or most) of their salary.”